Doomed To Repeat: A look at two market meltdowns
When deregulation combines with a booming real estate market and greed, it creates a culture that empowers corporations and individuals to act selfishly, with no temperance of risk, and leads to the economic failure that we’re mired in. The crazy thing is that this cycle replicates itself. In the late 1980s and early ’90s, the U.S. economy was hit with the Savings & Loan (S&L) Crisis. Now we’re in the midst of another economic crisis. In both cases, real estate speculation played a key role.
Back when acid-washed jeans were cool, S&L institutions were the Michael Jackson of the financial industry--they were hot for a while and then faded away. It went like this:
Customers deposited their savings in S&Ls and were paid interest. S&Ls, in turn, invested the money primarily in mortgage loans that paid the institution a higher percentage, thus making them money. This worked until higher-interest investment vehicles like money market funds came along and ruined the party.
Regulations restricted S&Ls from raising their interest rates or diversifying into other investments, keeping them from competing with these new products. Suddenly, customers started withdrawing their savings from S&Ls and putting them in these higher-return vehicles. In short, the cash flow started to dry up. It got to the point that the government loosened regulations and allowed S&Ls to invest more broadly in order to save themselves.
Unfortunately, S&Ls started taking on too much risk. Among the new favorite investments were junk bonds and speculative real estate. As a result, some S&Ls grew at a rate of 100% annually, especially in areas with booming real estate markets. But as the party spiraled out of control, poor investments enabled by lowered regulations caught up with them. As the real estate boom ended and junk bonds lost value, many S&Ls became insolvent, because their investments no longer had value. Congress tried to keep them afloat, but that caused huge losses to the Federal Savings and Loan Insurance Corporation (FSLIC), which insured S&L deposits.
Eventually the bubble completely burst, costing taxpayers $190 billion. More than 1,600 S&Ls collapsed, and the FSLIC was dissolved. But making money quickly with little foresight never goes out of style.
New Kids On The Block are back, and with their return comes another crisis built on deregulation, greed, and a busted real estate bubble. But unlike the S&L Crisis, this one has bigger consequences.
Back in 2002, the U.S. economy started pulling itself out of post-9/11 uncertainty. Constant preaching of the buy, buy, buy doctrine to stimulate the economy, in conjunction with the cutting of the federal funds rate to as low as 1% in 2003, encouraged people to spend and invest.
Cutting the federal funds rate drove interest rates lower, which in turn inspired a real estate boom, because mortgage rates were so low. The public, investors, loan firms, Wall Street and the real estate market all went crazy. Houses were selling like the latest platinum record. Everyone wanted in--even those who couldn’t afford it.
Enter: subprime mortgages. Mortgage lenders handed them out to pretty much anyone--you didn’t need money down or a reliable income--because house prices were going up, up, up, and the logic was that people could buy real estate, sell it and make a profit. Government regulations over Wall Street had been relaxed, allowing this bubble to keep expanding.
Wall Street began to build on this house of cards. Investment firms bought subprime mortgages, many with the lowest (riskiest) rating, from mortgage lenders, combined them with bonds in a package--which then received the highest rating--and sold them, along with even more complicated and risky securities, to investors worldwide.
The problem was that the real estate bubble started to burst in 2006: housing values (the lending institutions’ collateral) declined, subprime borrowers started defaulting on loans, and bonds and other securities backed by subprime mortgages became worthless.
By 2008, the ripple effect of so many investments losing value caused the failure of several major institutions and investment firms, and a simultaneous recession (two consecutive quarters of negative economic growth) in the U.S., Japan and Europe for the first time since World War II.
When regulations are relaxed and greed overrides common sense and fiscal responsibility, it creates the perfect climate for crisis. In both crises, everyone from financial and investment institutions to Average Joes took on too much risky debt, and a lot of them fell on their collective faces. What can you do? Don’t leverage yourself to the hilt or risk it all. Pay off your debt. Evaluate the market and make wise investments.
So far, the U.S. bailout for the most recent crisis has reached $3.45 trillion, U.S. household wealth has dropped by $10 trillion, and there are calls for stricter regulation of the financial industry. It may be a while before everything recovers, but hopefully we'll have finally learned our lesson when it does.
Sources: fdic.gov; lendingsolutionsgroup.net; Brief The Crisis, Condé Nast Portfolio, Dec. 2008/Jan. 2009, 44.; Lewis, Michael, “The End,” Condé Nast Portfolio, Dec. 2008/Jan. 2009, 114-123, 154,156-159; econlib.org; usatoday.com; time.com; investopedia.com; nytimes.com; money.cnn.com; fool.com; espn.go.com; time.com; finance.google.com; finance.yahoo.com; books.google.com; wiley.com; marketwatch.com; bloomberg.com
The third market meltdown is just around the corner. First it was the sub-prime mortgage crisis that caused the Great Recession now we are about to see the other shoe drop. That other shoe is the up coming foreclosure crisis, it's not a crisis yet but American homeowners are finally waking up and realizing that the Banks actually don't know who owns the mortgages they are foreclosing on. The banking practice to use MERS was their way to skirt US regulations and laws that require mortgages/titles to be filed with county courts. This banking practice is about to bite the banks in the ass now that the American people have finally woken up to the sham that Wall Street has been running. Even investors who bought these mortgages backed securities (MBS) are now challenging banks as to the legality of the sales. Investors are now questioning if $1.3 trillion in MBS are valid due to Banks not being able to pin point who owns what mortgage. Homeowners are now saying that Banks have no right to foreclose on their house because they don't own the mortgage while Investors are saying Banks sold them illegal MBS. This problem is only made worse because the court system is backed up with millions of foreclosures and now that there is possible fraud, the system will only get bogged down more. And previous foreclosures may end up being reversed. Its a giant mess. If banks had followed the letter of the law and filed sales/titles with county courthouses rather then going through a electronic database, they wouldn't have this problem and we wouldn't be headed for another crisis. Lets hope that the American taxpayers don't get stuck with the bill again this time!
That is a possibility. Also, asking the financial institution foreclosing your property is an excellent way to delay the process until you can get your feet under yourself again.
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